Companion Advisor: Techniques
A tightrope walker ready to traverse a cable over
Niagara Falls takes both a risk and a chance. The risk can be increased
or decreased depending on the walker's skills, amount of practice, safety
measures, and quality of equipment. You or I would be taking more risk than
an experienced performer.
How to analyze risk
The chance, however, is uncontrollable. A sudden attack
by birds or bolt of lightning could strike anyone, experienced or not.
Everyone would be taking the same chance.
Once you've decided to take the chance, one rule of investing is to measure
and control the risk. Before you and your investment adviser can plan
objectives, you must learn how to recognize the risks that exist in
various types of financial
instruments, and decide on your own personal apetite for such risk.
Risk is a measure of the possibility that you will not receive your expected
return on an investment. Generally, risk and reward move in the same direction
over time. Higher returns over a long time period are often the reward
that go with higher risk investments; but not always. Some investments
never make money and all too often lose the original capital as well.
A smart investor always measures the risk.
There are several types of risk that one must be aware
of when deciding where to invest money. One such risk is purchasing power
risk. This is the possibility that the return on your investment will
not keep up with inflation and as such your money will not buy as much
in the future as it will today. Any investment that generates low returns
relative to a rising cost of living, or where the original invested capital
is not expected to rise in value over time, suffers from purchasing power
risk. Usually fixed rate investments such as GICs or Bonds are most closely
aligned with purchasing power risk. When you buy one of these products
the yield is fixed until maturity so that no matter how high the cost
of living gets over the term of the investment, you investment return
won't be adjusted. Similarly the original invested capital loses buying
power over time during inflationary periods because although its value
will be the same at maturity as when the investment was made, those dollars
won't buy as much as when the investment was made. Variable return investments
such as stocks or mutual funds or even real estate are better equipped
to deal with inflation. The companies whose stock you or a mutual fund
own can usually adjust their product pricing to deal with inflation so
that their income and your subsequent dividend payments can keep pace
with higher costs. The invested capital as well generally increases over
time as the stocks gain in value. Real estate prices also normally rise
with inflation. Certainly stocks and real estate can lose value but this
is a different type of risk which is covered later..
A second kind of risk is financial risk. This is the
possibility you will not be able to recover your invested capital due
to the insolvency of the company whose stock or bonds you own. Financial
risk therefore is a measure of the quality of the investment you select
compared to other similar investments. Stocks as an asset class generally
have a higher financial risk than bonds because companies in financial
difficulty will pay bond interest before stock dividends. However within
a given asset class there are different levels of financial risk as well.
For example, Government bonds generally have less financial risk than
corporate bonds. Futhermore, each of these categories can be graded as
well according to their quality. Some corporate bonds
with a rating of B or lower are called junk
bonds, and are much more speculative in nature than a bond with a
double or triple A rating. Real estate may be subject to financial risk
if tenants suddenly leave, damage the property, or are unable to pay their
rent. Investments with relatively low financial risk include Canada Savings
Bonds, Government bonds, and bank and trust company deposits. Precious
metals and collectibles are usually unaffected by financial risk because
you actually hold a tangible asset.
A third form of risk , interest rate risk, results from uncertainty in
the direction of future interest rates and the impact that increasing
or decreasing rates will have on an investment. All interest-bearing investments
carry this risk. If for example you purchase a $20,000.00 bond with a
yield of 5% for a 10-year term and the following year interest rates for
similar quality bonds with comparable terms have risen to 7%, you will
have lost the opportunity to obtain the higher rate on your investment.
In addition if you try to sell your bond, a prospective buyer will not
give you $20,000 for it but instead will offer you a reduced price so
that they obtain a 7% yield on their money; otherwise they wouldn't buy
it. Interest rate risk increases with the length of the investment. In
the above example it the original term of the bond was 20 years instead
of 10 years, the prospective buyer would have to reduce his offer price
even further to generate a 7% yield over the additional 10 years. The
longer the term of the bond the greater its value will fall in periods
of rising interest rates and conversely the greater its value will rise
in periods of falling interest rates.
Market risk is the uncertainty of the future market
value of your investment due to investor demand. The more demand there
is for stocks in general, the more the increasing value of your investment
is less a result of the underlying fundamentals of the company is which
you invested and the more it is a result of prospective buyers bidding
up the price. Investor purchase mania can push stock prices to such high
levels that a significant crash in prices is inevitable once the buying
exuberance ends. Technology stocks are a good example, as they tend to
go in and out of favour quickly.
Political, exchange rate and social risks arise from
instability of governments, nationalization of industries, currency speculation,
and shifts in consumption and production patterns. With social risks,
for example, if certain foods are found to be unhealthy, those industries
may experience sudden drops in sales. Or, if changes in technology render
a product obsolete, production patterns will change. That explains the
low price of Amalgamated Buggy Whips.
One last form of risk is liquidity risk or the danger
that you will be unable to sell your investment when you choose because
either there isn't a market for this type of investment or there are insufficient
buyers. Good liquidity usually exists for Government and most corporate
bonds, Canada Savings Bonds, bank deposits, actively-traded common and
shares, and gold and silver bullion.
How do you sort through all these risks? It depends
on your circumstances. If you are young with time to recoup losses and
are interested in growth over the long term, you won't worry as much about
market risk. If however you are about to retire concerns about preserving
your capital may force you to avoid market risk but accept more interest-rate
and purchasing power risk. If you are planning changes in your lifestyle,
you may want to minimize your liquidity risk to enable to sell investments
quickly if you have to.
One very useful tool for managing risk is diversification:
holding different kinds of investments in varying amounts to spread out
the different types of risk.
With proper investment planning, what looks like
a tightrope walk over Niagara Falls can feel more like a stroll around
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